Sunday, January 16 2022

The past six months have seen a very welcome return to the style of value investing that has made value managers breathe a sigh of relief, notes asset management firm Schroders.

Simon Adler and Liam Nunn, fund managers, equity value of the financial services group note that since Pfizer’s successful vaccine announcement in early November, they have seen previously unloved sectors of the market recover quite sharply. . These included banking, energy, automotive, and advertising-dependent businesses.

Value’s recent outperformance is a quake, not an earthquake

But it’s important not to focus too much on short-term percentage price changes, because when you zoom out and look at the big picture, you can see that many stocks are still trading at valuations deeply. depressed.

The chart below shows that the dispersion of valuations within the market – the fundamental valuation differential between the highest rated and lowest rated stocks globally – remains at extreme levels.

The opportunity is still important

Value-to-growth assessments still close to their all-time low

The latest rebound in value performance is barely visible at the end of this chart.

The moves we’ve seen over the past few months may sound dramatic, but we think we’re watching a performance quake rather than a real earthquake. If valuation spreads in the market are to return to something more normal in the context of a long-term story, there seems to be a long way to go.

But we would also be cautious, the equity experts said.

Over the past couple of years, we’ve started to see the kind of crazy market behavior that typically happens at the peak of market cycles. In fact, this is exactly the sort of behavior that characterized the peak of dotcom mania in 1999/2000.

We believe the parallels between this period in market history – when the uptrend got seriously out of hand – and today are increasingly visible.

Reject the argument “this time it’s different”

But there are those who disagree. They argue that this time around, the companies that attract really high valuations are truly exceptional companies with strong fundamentals that are changing the world.

In other words, their compelling assessments are justified and this is just a new reality.

Our response is based on two observations:

1) Investors thought the same in 2000 too! The four biggest tech companies at the height of the boom were Microsoft, Intel, IBM, and Cisco. These were genuinely high quality companies that generated exceptional earnings growth and very attractive returns.

They were good companies, but they also turned out to be terrible investments if you bought them at the wrong price. In the three years since the peak of the Internet boom, they have fallen by 60% on average. Just because these tech giants are big, innovative and rapidly growing today, doesn’t mean people can’t lose money investing in them.

2) Even if you exclude the exceptional impact of the big tech winners at the top of the market indices, the valuation dispersion is still well above historically normal levels.

The two charts below show that if you exclude either the most expensive 5% of megacaps or the most expensive 10% in the universe, you get a similar picture: the difference between the most and least liked parts. of the market remains large, according to all history. Standard.

The more the “ quality this time ” argument seems compelling

But the valuation dispersion is much wider than that

This suggests to us that the trend of recent years cannot be explained as rational market behavior in the face of the emergence of a handful of exceptionally valuable companies.

It seems to us that the market has, once again, given up on the idea that fundamental valuation matters.
What happened when the music last stopped?

So what if we’re right and looking at a market backdrop that is eerily similar to 1999/2000?

What happened when the music stopped and the speculative growth party hangover kicked in?

From the peak of the stock cycle in March 2000, global stock indices entered a painful and prolonged bear market. Even five years after the peak, the MSCI World Index was still underwater in absolute terms, as you can see from the red bars below.

What happens when the music stops?

5 years after dotcom peak, global indices were still in red

During this same period, the overall value delivered a very strong period of absolute and relative performance, as you can see in the green bars below.

What happens when the music stops?

But the value behaved very differently from the larger market

Systematically avoiding the most excessively overvalued stocks in the years leading up to the summit had left value investors chastised and ridiculed by many investors.

But over time, sticking to only the cheapest areas of the market has come in handy.

It should be noted that value as a style often underperforms in the tail of a bull market. Trendy sectors of the market are skyrocketing and value investors are often left behind.

But when financial gravity starts to bite, value often does quite well. And it is during times of irrational exuberance that markets will present wonderful upside-down opportunities for investors willing to swim against the tide.

Find value in unexpected places

Some of these contrarian opportunities can be found in obvious segments of the market, such as banking and energy.

We think banks are very attractive, not least because they have record capital levels, have spent a decade reducing risk, and are part of the solution to the crisis (as opposed to the cause of it like this). was the case during the global financial crisis.).

Energy companies are another valuable area for later children. Finally, they exercise capital discipline, focusing on costs and returning capital to shareholders. This, combined with exposure to the potential rise in oil prices, presents a compelling opportunity.

We also found that a handful of exciting opportunities in Japan. In the past, we have avoided Japanese stocks on the grounds that many of them are value traps. But the stocks we are currently valuing have compelling valuations, carry relatively low risk, and historically have little correlation to other stocks we hold.

Then there are those parts of the market that were hit during the pandemic panic. Some high-quality companies have been unfairly sold during the Eye of the Storm, which has allowed us to acquire one-off buys that are expected to rebound as the world recovers from the pandemic.

These range from “turtle stocks” (i.e. likely to be slow and stable winners like food distribution and telecommunications) to “recovery stocks” (i.e. companies that have gone through a difficult period but are recovering and recovering).

Not too late

It is clear that there are many places to find real value in today’s market for the active investor and it is not too late to get involved.

We believe that the stock has a lot of advantages given current levels of valuation dispersion and that it can offer powerful protection in otherwise “hot” markets.

We continue to believe that value should have a long-term place in every client portfolio.

  • Through Simon Adler and Liam Nunn, Fund Managers, Equity Value at Schroders

Read: Are locals still reluctant to invest in South Africa?

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